THE NUMBERS GAME
In an attempt to burnish their image with investors and drive stock prices higher, companies are offering up a host of gerrymandered measures to make their costs appear lower, and their profitability higher. The use of these customized earnings measures that do not adhere to generally accepted accounting principles is growing in Canada, posing a quandary for both regulators and the investors they're charged to protect.
Imagine, if you will, something terrible: A fire begins in your home and rages, uncontrolled. No one is hurt, thankfully, because you're away from the house at the time. But the structure is ruined and, financially, you've just taken a huge blow – because you failed to renew your home insurance policy.
You are devastated. But your accountant advises you not to worry. After all, the destruction of your house is merely a non-cash loss.
The example may seem extreme, but the accountant's words are not unlike the message being offered to shareholders by many large public companies in Canada when they report sales and profits each quarter. In an attempt to burnish their image with investors and drive their stock prices higher, companies are offering up a host of gerrymandered measures to make their costs appear lower, to ignore real losses, and to make their profitability seem higher.
Restructuring costs, stock payments to executives, writeoffs from deals that went badly – all of these are being removed by corporate accountants who use "adjusted" measures of earnings. Company management justifies hiding some of these costs because, just like an uninsured house that burns down, they do not involve an immediate outflow of cash.
But the effect is often to deceive investors and to make many Toronto Stock Exchange-listed companies look healthier than they really are. Sometimes, the adjustments change the entire picture of a company's profitability. In the first quarter this year, for instance, BlackBerry Ltd. presented a number to investors that showed it broke even. But that figure excluded a litany of costs, including share payments to staff, some administrative costs, and writedowns of royalty agreements that were no longer as valuable as the company first thought.
The real bottom line for BlackBerry? Not break even. A loss of $670-million (U.S.). (BlackBerry tells investors it believes that presenting its earnings this way "enables it and its shareholders to better assess the company's operating performance … and improves the comparability of the information presented.")
The use by companies of customized earnings measures, called "non-GAAP" because they do not adhere to generally accepted accounting principles, is growing in Canada, as more companies cast aside tried-and-true accounting conventions. According to a new report from Veritas Investment Research Corp. provided exclusively to The Globe and Mail, 70 per cent of the members of the S&P/TSX 60 stock index of large public companies used some form of non-GAAP metric in their results as compiled by Bloomberg. In the United States, 63 per cent of companies in the Standard & Poor's 500 do so.
In 2004, just a handful of companies in the S&P/TSX 60 used non-GAAP measures somewhere in their annual reports. Today, 59 do. The only exception: Imperial Oil Ltd.
The majority of the accounting adjustments by TSX companies – at least 80 per cent – served to put a positive spin on the numbers, mostly by boosting measures of profitability. "Management isn't going to adjust numbers to make themselves look bad," says Jerome Hass, a partner at Lightwater Partners Ltd., a Toronto-based hedge fund.
And, in Veritas's view, about 35 per cent of the members of the S&P/TSX 60 may not be following the guidelines of Canadian securities regulators about how they should present financial numbers. For example, the Canadian Securities Administrators calls on companies to present their GAAP earnings figures with at least as much prominence as their non-GAAP measures – something a number of companies seem to be failing to do.
The new report from Veritas presents a quandary for both Canadian regulators and the investors they're charged to protect. In the United States, the Securities and Exchange Commission is cracking down on abuses in non-GAAP reporting. In Canada, securities commissions have been more lax, offering "guidance" instead of firm rules, reminding companies of what to do – and weighing whether more action is needed.
In the meantime, investors must navigate an ocean of conflicting and contradictory measures that typically serve to inflate companies' earnings – and, as a result, the stocks' valuation. After all, investors are paying for companies' earnings, now and in the future. And if the companies can convince investors and analysts that their earnings are higher than what accounting rules require, their stock prices will follow – at least for a while. "Valuations are attached to inflated earnings, so valuations are higher than average investors believe them to be," Mr. Hass says.
"This is the root of all evil, the current No. 1 problem in financial reporting," says Anthony Scilipoti, Veritas's chief executive officer and a co-author of the report. "The regulators, investors, the auditors – this is a challenge for everyone involved. … It's gotten out of control, and investors can't assess what the truth is."
The use of non-GAAP measures is not brand new. The trend began in earnest during the technology-driven stock market boom of the late 1990s. The bursting of the bubble, as well as the Enron and WorldCom accounting scandals that followed, brought greater scrutiny to the use of "pro forma" earnings, or what has also been called "earnings before bad stuff."
While the SEC took action against companies for abuses in earnings announcements – the first major case, in 2002, was against Trump Hotels & Casino Resorts Inc. – the Sarbanes-Oxley Act in the U.S. later that year codified their regulation. Rather than ban the use of these measures, however, the United States allowed them, as long as certain rules were followed.
Chief among them was the regulation that the GAAP measure be at least as prominent as the non-GAAP measure, as well as the rule that companies must provide a clear explanation of how they calculated the latter. (This is known as a reconciliation.) Canadian regulators' guidance is markedly similar.
Once companies received the blessing of regulators to use their own accounting metrics, however, the predictable happened: More and more companies used them, and used them to exclude more and more expenses.
In a study published earlier this year, Jack Ciesielski of the Analyst's Accounting Observer found that 401 members of S&P 500 firms were reporting earnings on a non-GAAP basis; of those, just 269 were using such figures in 2009.
All told, the 380 firms that also existed in 2009 collectively reported $804-billion in non-GAAP income in 2015. But using standard accounting rules, the real profit figure was $562-billion.
For investors, the difference is a significant one. While the companies' customized measures allowed them to show a gain in profits of 6.6 per cent last year, their net income, if measured conventionally, actually fell by 10.9 per cent over the same period. "Call it 'Wonder Bread,'" Mr. Ciesielski says. "The firms make their bread, but you should wonder how."
What kinds of things are companies leaving out? Canadian companies are making the same fundamental choices as U.S. companies, Veritas has found. Some of the major categories:
Asset impairments: Investors in energy or mining companies are well versed in this expense item. When a company has an asset on the books that has suffered a decline in value, it must write down its value, with the amount of the writedown charged directly to earnings.
Since there's no cash used at the time of the writedown, companies often exclude the charge from their quarterly numbers. Kinross Gold Corp. is an example. In 2010, it acquired Red Back Mining Inc., creating what it billed as a "gold growth powerhouse." But the deal proved to be a disaster and Kinross has now taken $7.5-billion in writedowns on its purchase, a number that exceeds its $5.6-billion market capitalization on the New York Stock Exchange.
Stock option compensation expenses: Companies that were heavy users of stock options, as well as industry trade groups, engaged in a multiyear battle to keep stock options from appearing on the income statement as an expense. They lost, and the cost of options began to hit the bottom line in 2005.
Since then, many companies adjust their quarterly earnings to exclude their cost. Agnico Eagle Mines Ltd. had $24.6-million in 2015 net income using International Financial Reporting Standards. But it added back $19.5-million in stock options expenses, along with other items, to get to $93-million in "adjusted net income."
Restructuring or other "non-recurring" expenses: Companies argue that severance payments and other costs associated with buying another firm are one-time in nature, so they leave them out of quarterly earnings – but then, the next quarter, they announce another acquisition, and another batch of one-time charges appears, only to be excluded again. BCE Inc. has adjusted for "severance, acquisition and other costs" each year for the past five years.
"One of the more common justifications for many earnings adjustments is that they are 'non-cash expenses' and therefore should be excluded," Mr. Scilipoti wrote in the Veritas report. "This line of reasoning falls down for two reasons: One, earnings are not a cash metric and are not supposed to be. Two, investors interested in cash generation can and should look at the cash flow statement."
Adjusting for items that are non-cash "simply produces earnings metrics that management has created without giving investors a clear picture of either earnings or cash flow," he writes. In other words, these adjusted profit figures are sometimes designed to confuse or obfuscate, instead of clarify matters.
Some institutional investors are so unimpressed with the accounting games that they simply ignore profitability measures that are being promoted by management. Take one of the most widely used non-GAAP measures, EBITDA, which stands for earnings before interest, taxes, depreciation and amortization. "It is shocking to me how many companies in heavy capital-expenditure-required industries are touting EBITDA. For them, depreciation is a real expense," says Barry Schwartz, chief investment officer at Baskin Wealth Management in Toronto. "We generally skip the income statement" and focus on how much cash flow the company is producing – since that's harder to manipulate than earnings disclosures.
One of the poster children for non-GAAP earnings – although surely the rest of the S&P/TSX 60 will dislike the comparison – is Valeant Pharmaceuticals International Inc., a company that Veritas put in its crosshairs several years ago.
The Laval, Que.-based company had an explicit business model of shunning research and development costs, instead buying other companies or specific drugs that it thought it could make more profitable from cost-cutting or price increases. However, in its earnings report, Valeant removed the cost of amortizing the assets it had acquired, saying these "non-cash" expenses didn't reflect the company's earnings power.
This made it nearly impossible to compare Valeant's earnings figures to those reported by other pharmaceutical companies that included research and development costs every quarter. And it had the effect of allowing Valeant's preferred earnings measure to balloon, even as it posted losses. Investors bought into the growth story and Valeant briefly became the largest company on the Toronto Stock Exchange – until its share prices collapsed under the weight of questions about its sales practices and accounting. It's now under investigation by the U.S. Securities and Exchange Commission and the U.S. Department of Justice (and the company has acknowledged it had a "tone at the top" problem with its now-departed management).
The widespread use of these adjustments, however, suggests a belief among management that standard accounting rules – International Financial Reporting Standards for most Canadian public companies, U.S. GAAP for others – are not flexible enough to completely reflect how a company is actually performing.
"We believe that GAAP, and having a set of standards that everyone has to follow as a basis, is very important – it sets a level playing field," says Susan Campbell, the chair of the Committee on Corporate Reporting at Financial Executives International Canada, a group for chief financial officers and other finance professionals.
"However, there are many different industries, and many different things that can impact a specific company or industry that is not captured within IFRS … so a non-GAAP measure gives a company the ability to tell more of the business story of the specific entity, something that explains its performance a little more clearly than just the strict GAAP statements do."
Regardless of the merits of the non-GAAP metrics, companies are supposed to make clear to investors exactly what they're doing – and in this, Veritas argues that many of Canada's largest public companies are falling short.
The most frequent problem, Veritas says, is that companies are failing to show how they change their GAAP numbers to the non-GAAP ones: They're supposed to provide a clear reconciliation between the two. They're also supposed to tip off investors the very first time the non-GAAP number is used that there's a place where they can find that reconciliation. Veritas found 14 members of the S&P/TSX 60 with this potential issue.
A less frequent, but also problematic, issue is companies' failure to name their non-GAAP measure in a way that distinguishes it from a similar earnings metric. One company tagged by Veritas for this problem is Pembina Pipeline Corp., which in its 2015 annual report defined EBITDA as excluding not just interest, taxes, depreciation and amortization, but also unrealized losses on derivatives. (A Pembina spokesman notes the company abandoned the practice this year and says his company should not be used as an example of this problem.)
Veritas has some recommendations for how Canadian regulators should deal with the wave of new accounting measures being crafted, and some practices companies could engage in to make them better. One may be counterintuitive: Veritas believes a company's auditors should not be responsible for reviewing any measures that don't comply with generally accepted accounting principles. When an auditor signs off on "adjusted net income" that pumps up a company's profitability, it "has the potential to create a false sense of security," Veritas writes. If the auditor reviews the metric, Veritas says, investors may view the number as correct. Instead, the firm says, "adjustments proposed by management should be carefully considered by investors."
Veritas also believes regulators should step in and explicitly prohibit companies from playing certain games with the numbers – such as excluding stock-based compensation expenses. Stock options and share units are just like salaries: a way of paying employees, and a real cost of doing business. Also, says Veritas, companies that present a metric that deviates from a standard definition, such as EBITDA, should have to refer to it as "adjusted" so as to avoid investor confusion.
While regulators may react to the widespread use of non-GAAP earnings, the greater risk is that investors will take the lead and react sharply to the broad use of non-GAAP metrics, as they ultimately did with Valeant, which plunged 90 per cent from its all-time high.
"Last time we saw frequent, extensive use of non-GAAP measures was in the late 1990s, and it was used to support high valuations for companies that were not generating sufficient profits, or any profits at all, to support their valuations," says Lynn Turner, who was the chief accountant at the SEC in that period.
"At that point in time, the executives were saying the exact same thing as they're saying today, that 'GAAP doesn't really present our company as it should.' We know how that story ended: It had a very bad outcome. Investors lost something like $7-trillion [in stock market capitalization] by the time the dot-com explosion ended and the corporate scandals came to light. It's a classic story of history repeating itself, and this time isn't going to be any different."
With files from Tim Shufelt